Basis allocation rules for distributions of multiple assets.

EXECUTIVE SUMMARY

* The allocation of basis among noncash assets requires the bifurcation of such assets into two categories.

* The increase procedure only applies to liquidating distributions; its use is required when the allocable outside basis exceeds the carryover basis of the assets distributed to the partner in liquidation.

* The distribution rules are further complicated when the property distributed is subject to depreciation recapture.

Changes made by the Taxpayer Relief Act of 1997 and the Internal Revenue Service Restructuring and Reform Act of 1998 altered the way basis is allocated to property distributed to partners in liquidating and nonliquidating distributions. The rules were amended to prevent basis shifting. This article's many examples illuminate these rules and offer planning guidance.

For many years, the basis of property to distributed partners was allocated under Sec. 732(c) without regard to the property's fair market value (FMV). Basis allocations (if any) to the distributee partner's assets were premised on the adjusted bases of the properties distributed and, in certain cases, on the distributed assets' relative adjusted bases; any relation to the properties' FMVs was mere coincidence. This produced some interesting results--assets were sometimes allocated bases well above or below their FMVs. The Taxpayer Relief Act of 1997 (TRA '97), Section 1061, changed the method of allocating basis to distributed properties to more closely reflect their FMVs. The IRS Restructuring and Reform Act of 1998 (IRSRRA '98), Section 6010(m), clarified the TRA '97 provision. Recent final regulations provide further guidance.(1) These changes have had a major effect on the basis of property distributed to partners.

This article reviews the property distribution rules in light of the changes to Sec. 732(c) and compares the treatment of such distribution to partners before and after the law changes, for both nonliquidating (i.e., current) and liquidating distributions. Many examples are provided throughout the article,(2) as are planning opportunities.

Background

A partner's basis in his partnership interest (outside basis) is continually adjusted for contributions, distributions, liability share and distributive share of partnership income, gains, deductions and losses, in contrast to the partnership's basis in its assets (inside basis). In theory, inside basis for partnership assets should equal outside basis for all partnership interests. A (sometimes fleeting) goal of partnership taxation is to keep inside basis equal to outside basis.(3)

In accounting for a partner's outside basis, positive items are generally considered before negative items. Contributions to the partnership and a partner's distributive share of partnership income and gain items increase basis. Negative items (e.g., distributions(4) and a partner's share of deduction and loss items) are considered next. Distributions affect a partner's basis before his share of deduction and loss items is considered, because (1) distributions of cash in excess of basis generate capital gain and (2) the Sec. 704(d) loss limitation rule disallows a partner's loss deductions to the extent his distributive share of loss exceeds his basis after distributions, but before losses. The sequence of basis adjustments is summarized as follows:

Partner's basis adjusted for liabilities
+ Partnership contributions
+ Distributive share of partnership
income and gain items

Basis before distributions
- Distributions from the partnership to
the partner

Basis before losses
-Distributive share of partnership deduction
and loss items

Ending basis

When considering partnership distributions, the starting point is a partner's basis before distributions (i.e., the basis available to be adjusted for the effect of distributions).

Example 1: A, a partner in ABC Partnership, has a $30,000 basis in her partnership interest, after liabilities. During the year, she made a $10,000 contribution to the partnership. Her distributive share of partnership income was $60,000. Her basis before considering distributions for the year is $100,000 ($30,000 + $10,000 + $60,000).

Cash distributed to a partner is the first item to be considered when applying the distribution rules (except when Sec. 751(b) provides otherwise). This is true whether or not the distribution is liquidating. If the cash distributed is greater than the partner's basis before distribution, it triggers a capital gain to the extent of the excess. Thus, a partner's outside basis is reduced to zero; the excess is capital gain. This treatment follows the Sec. 733 rule that a partner's outside basis can never be negative.

Example 2: The facts are the same as in Example 1. A, whose predistribution basis is $100,000, receives a cash distribution of $120,000. Her outside basis is reduced to zero; she reports a $20,000 capital gain ($120,000-$100,000).

When a partner receives property other than cash, two things occur simultaneously: (1) he takes a basis for the property distributed (under Sec. 732) and (2) his outside basis is reduced by the basis allocated to the property received (under Sec. 733). Under Sec. 732(a) and (b), the ceiling on the amount of basis allocated to noncash property is the outside basis remaining after reduction by any cash distribution (for both liquidating and nonliquidating distributions). Again, a partner's outside basis cannot be reduced below zero.

Example 3: B, a partner in BCD Parnertship, has an $80,000 predistribution outside basis. He receives a $30,000 cash distribution and two parcels of land. The maximum basis that can be assigned to the land is the predistribution basis adjusted for the cash distribution, or $50,000 ($80,000 - $30,000). This is also the maximum reduction in B's outside basis, because it cannot be reduced below zero.

Basis Allocation for Noncash Property

Noncash property is bifurcated into two categories; basis is allocated to the assets in these categories in the order detailed in Sec. 732(c). This allocation scheme was changed by the TRA '97 and IRSRRA '98. Basically, the categories and allocation order have remained the same; however, the pre-TRA '97 allocation scheme considered only the adjusted basis of property distributed. The new allocation scheme considers adjusted basis, FMV and unrealized appreciation and depreciation.

The allocation of basis among noncash assets requires the bifurcation of such assets into two categories. Category 1 consists of unrealized receivables and inventory items, "hot assets" that generate ordinary income. Category 2 contains all other assets (i.e., noncash, nonhot assets). Basis is allocated first to Category 1 assets to the extent of their inside (adjusted) basis to the partnership; any remaining basis is allocated to Category 2 (i.e., other noncash) assets to the extent of their adjusted basis to the partnership. In a nonliquidating distribution, this allocation scheme is identical to pre-TRA '97 law if there is sufficient outside basis to assign a carryover inside basis to the assets received.

Example 4: C, a partner in CDE Partnership, has a $25,000 outside basis in her partnership interest immediately before a nonliquidating distribution. She received the following assets in the distribution:

               Adjusted basis    FMV

Cash            $ 4,000          $ 4,000
Unrealized
receivables     $   -0-          $10,000
Land            $14,000          $20,000

C's outside basis is reduced as follows:

C's outside basis    $25,000
Less: Cash             4,000

                     $21,000
Less: Unrealized
receivables              -0- (carryover basis)

                     $21,000
Less: Land            14,000 (carryover basis)

Ending basis         $ 7,000

Thus, C's outside basis is reduced from $25,000 to $7,000 as a result of the distribution. Cash reduced basis first, with unrealized receivables (Category 1) next and land (Category 2) last. C takes a carryover basis in both the receivables (zero) and the land ($14,000). Because there is adequate outside basis to assign a carryover basis to the assets, the results after the law changes are identical to those under pre-TRA '97 law. In both cases, the assignment of a carryover basis to the assets distributed is accomplished without further adjustments.

When a partner's allocable outside basis is greater or less than the adjusted bases of distributed assets, equalizing adjustments are required. For this purpose, an increase or a decrease procedure must be followed under Sec. 732(c) that differs from pre-TRA '97 law. The decrease procedure may apply in either liquidating or nonliquidating distributions; the increase procedure applies only to the former.(5)

Decrease Procedure

Sometimes, there is insufficient outside basis to assign a carryover basis to assets received by a partner; in such cases, the decrease procedure must be used. This procedure applies when a shortage exists among Category 1 assets or among Category 2 assets after all Category 1 assets have received a carryover basis. In either case, the decrease procedure first allocates the decrease to assets within a category, in proportion to their relative unrealized depreciation; however, the allocated decrease cannot be greater than the unrealized depreciation. Any remaining decrease must then be allocated in proportion to the assets' relative adjusted bases, after adjustment for the first allocation under the decrease procedure.

Example 5: D has a $15,000 outside basis in her DEF Partnership interest immediately before a nonliquidating distribution. She received the following assets in the distribution:

                                           Unrealized
               Adjusted basis    FMV       appreciation/
                                           (depreciation)

Cash              $6,000         $6,000          $ -0-
Inventory A       $4,000         $3,500          $ (500)
Inventory B       $8,000         $9,000          $ 1,000

D's bases in distributed assets are computed as follows:

D's outside basis    $15,000
Less: Cash             6,000

                     $ 9,000
Less: Inventory A      4,000 (carryover basis)
Less: Inventory B      8,000 (carryover basis)

Required decrease    $(3,000)

In this case, only cash and Category 1 assets (inventory) are distributed. D's outside basis is reduced from $15,000 to $9,000 as the result of the cash distribution. The two types of inventory have a total basis of $12,000, $3,000 more than the remaining outside basis; thus, the decrease procedure must be used to reduce each type of inventory's basis below the carryover amount.

First, Inventory A's basis is reduced by $500, its unrealized depreciation ($3,500 - $4,000). Inventory B has appreciated by $1,000, so it is not adjusted in this step. The remaining decrease, $2,500, must be allocated among the inventory assets based on relative bases adjusted up to this point. Inventory A has a $3,500 basis ($4,000 - $500); Inventory B has an $8,000 basis. Thus, $761 (($3,500/$11,500) x $2,500 remaining decrease) is allocated to Inventory A; $1,739 (($8,000/$11,500) x $2,500) is allocated to Inventory B.

D thus takes a zero basis in her partnership interest and the following bases in the two inventory items:(6)

Inventory A    $2,739 ($4,000 - $500 - $761)
Inventory B    $6,261 ($8,000 - $0 - $1,739)

Example 6: The facts are the same facts as in Example 5, except that Inventory B has a $6,000 FMV. Because both Category 1 assets have unrealized depreciation, the decrease must be allocated pro rata based on relative unrealized depreciation. However, the allocation is limited to the actual decline in value.

                                    Actual
                                  unrealized      Allocated
               Pro rata amount    depreciation    decrease

Inventory A       $ 600(*)          $ 500           $ 500
Inventory B       $2,400(**)        $2,000          $2,000

(*) ($500/$2,500) x $3,000

(**)($2,000/$2,500) x $3,000

With $2,500 of the $3,000 decrease allocated, the remaining $500 must be allocated based on the assets' relative bases (adjusted up to this point). For Inventory A, the adjusted basis is $3,500 ($4,000 - $500); $6,000 ($8,000 - $2,000) for Inventory B. Thus, the $500 remaining decrease is allocated as follows:

Inventory A    $184 ($500 x ($3,500/$9,500))
Inventory B    $316 ($500 x ($6,000/$9,500))

D takes the following bases for the inventory after the decrease procedure:

Inventory A    $3,316 ($4,000 - $500 - $184)
Inventory B    $5,684 ($8,000 - $2,000 - $316)

If there were sufficient basis for all Category 1 assets to receive a carryover basis, the same decrease procedure would apply to allocate the decrease among the Category 2 assets.

Example 7: E has a $15,000 outside basis for his EFG Partnership interest immediately before a nonliquidating distribution. He received the following assets in the distribution:

                                         Unrealized appreciation/
             Adjusted basis     FMV         (depreciation)

Cash            $5,000         $5,000         $ -0-
Inventory       $4,000         $4,500         $ 500
Parcel 1        $4,500         $6,000         $1,500
Parcel 2        $3,000         $4,000         $1,000

E's bases in the distributed assets are computed as follows:

E's outside basis    $15,000
Less: Cash             5,000

                     $10,000
Less: Inventory        4,000 (carryover basis)
Remaining basis      $ 6,000

Less: Parcel 1         4,500 (carryover basis)
Less: Parcel 2         3,000 (carryover basis)

Required decrease    $(1,500)

In this case, $6,000 of outside basis remains after the cash and inventory are distributed. This is insufficient to give the land a full carryover basis. Thus, a $1,500 decrease must be allocated to the land bases via the decrease procedure. Because neither of the parcels has unrealized depreciation, none of the decrease can be allocated based on relative depreciation; the entire decrease must be allocated based on the parcels' relative adjusted bases. (This yields the same results as under pre-TRA '97 law.) Parcel 1's basis is reduced by $900 ($1,500 x ($4,500/$7,500)); Parcel 2's basis is reduced by $600 ($1,500 x ($3,000/$7,500)). E's basis in Parcel 1 is $3,600 ($4,500 - $900); his basis in Parcel 2 is $2,400 ($3,000 - $600).

Increase Procedure (Liquidating Distributions)

The above discussion focused on situations in which there was insufficient outside basis to allow a full carryover basis for all the assets distributed. The decrease procedure was used to determine the basis of assets to the distributee partner. This procedure also applies to liquidating distributions when there is insufficient basis to allow a full carryover basis to the assets. The results and steps taken in Examples 5-7 above would be the same if the distributions were in liquidation of the partner's interest.

On the other hand, the increase procedure only applies to liquidating distributions and is required when allocable outside basis exceeds the carryover basis of the assets distributed to the partner in liquidation. This occurs only in liquidating distributions, became the partner's outside basis must be reduced to zero. There is no such requirement for nonliquidating distributions, because the partner continues as a partner after the distribution. Similarly, no loss is recognized by a partner receiving a nonliquidating distribution; any remaining basis may still be recovered in the future. In contrast, a loss may be recognized on a liquidating distribution when the partner receives only cash, unrealized receivables and inventory.(7)

Example 8: F has a $50,000 outside basis in her FGH Partnership interest. The partnership distributes $40,000 and inventory with a $6,000 basis and $10,000 FMV in liquidation of her interest. Because the cash ($40,000) plus the adjusted basis of the inventory ($6,000) is $4,000 less than F's outside basis, she recognizes a $4,000 capital loss on the distribution. If a non-Category 1 asset (e.g., land) were distributed as part of the transaction, F would recognize no loss.

The increase procedure applies to a liquidating distribution whenever the loss recognition rule does not apply, all distributed assets have been assigned a carryover basis and outside basis remains. In such case, additional basis has to be assigned to some assets, to reduce ending outside basis to zero. If only cash and Category 1 assets are distributed in the liquidation, the increase procedure will not apply (because any excess basis is recognized as capital loss); thus, no increase in basis will ever be made to Category 1 assets via the increase procedure. If Category 2 assets are distributed and additional basis remains after considering carryover basis, it is assigned to the Category 2 assets.

The increase procedure first assigns the increase to Category 2 assets that have appreciated in value based on relative appreciation; however, the increase for each such asset is limited to actual appreciation. Any outside basis remaining after this step is allocated among the Category 2 assets based on relative FMVs, reducing a partner's outside basis to zero.

Example 9: G has a $60,000 outside basis in his GHI Partnership interest. The partnership distributed the following assets to him in liquidation of his interest:

                                          Unrealized appreciation/
             Adjusted basis    FMV           (depredation)

Cash            $10,000        $10,000           $ -O-
Inventory       $ 2,000        $ 4,000           $2,000
Parcel 1        $ 6,000        $10,000           $4,000
Parcel 2        $18,000        $24,000           $6,000

G's bases in the distributed assets are computed as follows:

G's outside basis          $60,000
Less: Cash                  10,000

                           $50,000
Less: Inventory              2,000 (carryover basis)

Remaining outside basis    $48,000
Less: Parcel 1               6,000 (carryover basis)
Less: Parcel 2              18,000 (carryover basis)

Remaining outside basis    $24,000 (increase needed)

In this case, $48,000 of outside basis remains after the cash and Category 1 asset are distributed, sufficient to give the Category 2 assets a full carryover basis. However, G's outside basis must be reduced to zero. Thus, the land bases must be increased $24,000 under the increase procedure. Because both of the parcels have appreciated, the first step is to allocate file increase based on relative appreciation, computed as follows:

Parcel 1    ($4,000/$10,000) x $24,000 = $9,600
Parcel 2    ($6,000/$10,000) X $24,000 = $14,400

Because the results exceed each parcel's actual appreciation, the allocation is limited to actual appreciation. Thus, a $4,000 increase applies to Parcel 1; a $6,000 increase applies to Parcel 2. Allocation of the remaining $14,000 of outside basis ($24,000 - $10,000) is based on relative FMVs. The basis increases of $4,118 to Parcel 1 and $9,882 to Parcel 2 are computed below.

Remaining outside basis    $24,000     (increase needed)
Increase Parcel 1           (4,000)    Step 1 (limited to
                                       actual appreciation)
Increase Parcel 2           (6,000)    Step 1 (limited to
                                       actual appreciation)

Remaining outside basis    $14,000
Increase Parcel 1           (4,118)    Step 2 (($10,000/$34,000)
                                       x $14,000)
Increase Parcel 2           (9,882)    Step 2 (($24,000/$34,000)
                                       x $14,000)

Ending outside basis       $   -0-

G takes the following bases in the assets received:

Inventory    $2,000
Parcel 1     $14,118 ($6,000 + $4,000 + $4,118)
Parcel 2     $33,882 ($18,000 + $6,000 + $9,882)

Depreciation Recapture

The above discussion centered on the application of the TRA '97 basis rules to distributions of multiple assets to a partner. The analysis covered liquidating and nonliquidating distributions and the application of the decrease and increase procedures. Another complication is the distribution of property subject to depreciation recapture. IRSRRA '98, Section 6010(m), clarified the allocation of basis to such properties. For purposes of the Sec. 732(c) allocation rules, "unrealized receivables" are defined as in Sec. 751 (c), including items that give rise to ordinary income (e.g., Secs. 1245 and 1250 depredation recapture).(8) Thus, in applying the increase procedure, any unrealized appreciation in property subject to depreciation recapture does not include any amount that would be treated as ordinary income if the property were sold at FMV; instead, depreciation recapture is treated as a separate asset--an unrealized receivable with a zero basis and an FMV equal to the depreciation taken.(9) This results in the depreciable asset having little or no appreciation, because the FMV is split with the unrealized receivable (the basis remains with the depreciable asset). This bifurcation preserves the depreciation recapture potential and allocates less basis to these depreciable assets relative to other assets.

Example 10: Equipment with a $30,000 FMV, a $10,000 adjusted basis and $20,000 of potential depreciation recapture is distributed to a partner in liquidation of his interest; thus, two assets are deemed distributed:

              Adjusted basis    FMV

Unrealized    $   -0-          $20,000
receivable
Equipment     $10,000          $10,000

The receivable is a Category 1 asset; the equipment is a Category 2 asset for purposes of the basis allocation rules.

Example 11: ABC Partnership has three equal partners (A,B and C) and the following assets:

                           Adjusted basis    FMV

Capital asset 1             $20,000          $25,000
Capital asset 2             $20,000          $25,000
Capital asset 3             $20,000          $25,000
Depreciable equipment 1     $ 5,000          $30,000
Depreciable equipment 2     $ 5,000          $30,000
Depreciable equipment 3     $ 5,000          $30,000

For each piece of equipment, the potential depreciation recapture potential is $25,000 ($30,000 - $5,000). In liquidation of A's partnership interest, ABC distributes to him Capital asset 1 and Depreciable equipment 1. A's outside basis in his partnership interest before the distribution is $60,000; the distribution is pro rata with no Sec. 751 effects. For purposes of the basis allocation rules, A has received three assets:

                           Adjusted basis      FMV

Unrealized receivable       $  -0-            $25,000
(recapture)
Depreciable equipment 1     $5,000            $ 5,000
Capital asset 1             $20,000           $25,000

                           Unrealized
                           appreciation

Unrealized receivable       $25,000
(recapture)
Depreciable equipment 1     $   -0-
Capital asset 1             $ 5,000

The Sec. 732(c) basis allocation is as follows:

A's predistribution outside basis    $60,000
Less: Cash                               -0-

Remaining outside basis              $60,000
Less: Unrealized receivable              -0- (carryover basis)

Remaining outside basis              $60,000
Less: Capital asset 1                (20,000)(carryover basis)
Less: Depreciable equipment 1          (5,000)(carryover basis)

Remaining outside basis              $35,000 (increase needed)

The allocation of the increase is based first on the relative appreciation of the Category 2 assets. Because only Capital asset 1 has appreciated, the increase is allocated to it in an amount not to exceed the $5,000 of actual appreciation.

Increase to Capital asset 1    $ 5,000

Remaining outside basis        $30,000 (remaining increase)

The allocation of the remainder of the increase is based on the relative FMVs of the assets, as follows:

Increase to Capital
asset 1                    $25,000    ($25,000/$30,000)x $30,000
Increase to Depreciable
equipment 1                $ 5,000    ($25,000/$30,000) x $30,000

Ending outside basis       $   -0-

The resulting bases of the assets to A are as follows:

Unrealized receivables     $  -0-
Capital asset 1            $50,000 ($20,000 + $5,000 + $25,000)
Depreciable equipment 1    $10,000 ($5,000 + $5,000)

As a result, the potential depreciation recapture for Depreciable equipment 1 is preserved as future Ordinary income. The potential capital gain from the future sale of Capital asset 1 is reduced,(10) exactly the result intended by the IRSRRA '98 clarification.

Example 12: The facts are the same as in Example 11, except that the IRSRRA '98 clarification does not apply. Only two assets are deemed to be distributed: a capital asset with a $25,000 FMV and a $20,000 adjusted basis and depreciable equipment with a $30,000 FMV and a $5,000 adjusted basis. The allocation of basis is as follows:

A's outside basis before
distribution                   $60,000
Less: Cash                         -0-
Remaining outside basis        $60,000
Less: Category 1 assets            -0-           (none absent
                                                 clarification)
Remaining outside basis        $60,000
Less: Capital asset             20,000)          (carryover basis)
Less: Depreciable equipment     (5,000)          (carryover basis)
Remaining outside basis        $35,000           (increase needed)
Increase to capital asset       (5,000)(*)
Increase to equipment          (25,000)(**)
Remaining basis                $ 5,000           (increase needed)
Increase to capital asset       (2,273)(***)
Increase to equipment           (2,727)(****)
Ending outside basis            $   -0-

(*) ($5,000/$30,000 relative appreciation) X $35,000 (limited to actual of $5,000)

(**) ($25,000/$30,000 relative appreciation) x $35,000 (limited to actual of $25,000)

(***) ($25,000/$55,000 relative FMV) x $5,000

(****) ($30,000/$55,000 relative FMV) x $5,000

The resulting asset bases to A are as follows:

Capital asset            $27,273    ($20,000 + $5,000 + $2,273)
Depreciable equipment    $32,727    ($5,000 + $25,000 + $2,727)

Under the clarification, when depreciation recapture is treated as a separate asset (i.e., as an unrealized receivable), the basis allocated to the equipment relative to the capital asset is reduced by $27,727, as compared to the treatment without the clarification.

                         Example 11        Example 12
                         (with             (without
                         clarification)    clarification)

Capital asset            $50,000           $27,273
Depreciable equipment    $10,000           $32,727

                         Difference

Capital asset            $22,727
Depreciable equipment    ($22,727)

Planning Considerations

The IRSRRA '98 clarification changed the strategy for distributing depreciable property to a partner. Before the clarification requiring depreciable property to be viewed as two assets (unrealized receivable and the asset itself), the strategy was to distribute appreciated depreciable assets.

The partner would get a much higher basis allocated to the depreciable asset (than after the clarification), resulting in increased future depreciation deductions. The clarification generally negates this strategy, because it reduces the basis allocated to the depreciable asset. However, careful choice of the assets to be distributed with the depreciable asset can increase the basis available for future depreciation deductions.

"Decrease" Scenario

In a potential "decrease" situation, the goal should be to allocate as little of the decrease as possible to the depreciable asset, to maximize the basis available for future depreciation deductions to the distributee partner. To achieve this, it is best to distribute a depreciable asset with a nondepreciable asset (e.g., land) that has a relatively low basis and has appreciated (because the decrease procedure relies exclusively on adjusted bases, relative depreciation and relative adjusted bases to allocate basis among multiple assets distributed). When a low-basis, appreciated nondepreciable asset (e.g., land) is distributed, less basis is allocated to it, resulting in higher basis being allocated to the depreciable asset. Exhibit 1 below illustrates this for a decrease situation, under the following facts:

Partnership interest FMV    $40,000
Partner's outside basis     $20,000
Equipment FMV               $25,000
Equipment adjusted basis    $15,000
Potential depreciation
recapture                   $10,000
Land FMV                    $15,000
Land adjusted basis         $5,000 - $30,000

For points 1-3 in Exhibit 1 on p. 648, the land basis is low; the land has appreciated in FMV. Point 4 represents land with an adjusted basis equal to its FMV. Points 5-7 represent land that has declined in FMV. For all appreciated land scenarios, the basis allocated to the equipment exceeds that for all nonappreciated land scenarios. The greater the appreciation, the greater the basis allocated to the equipment. For all nonappreciated land scenarios, the same, less favorable result occurs, regardless of the relative amounts of land and equipment distributed.(11) Thus, it is best to distribute lower-basis, appreciated land with equipment to maximize the basis allocated to the latter in a decrease situation, under the facts presented.(12)

Another option is to distribute cash in lieu of, and in an amount equal to the FMV of, the nondepreciable asset. For the facts presented, this option will always yield less basis allocated to the depreciable asset, regardless of whether the nondepreciable asset has unrealized appreciation or depreciation. For example, only $5,000 of basis is allocated to equipment if cash is distributed in lieu of land (holding all other variables constant). This is $5,000 less that the $10,000 minimum allocated to equipment when land is distributed (under Exhibit 1). Thus, a distribution of cash when land is available is not a good alternative if the goal is to maximize the basis of the equipment distributed.

[EXHIBIT 1 ILLUSTRATION OMITTED]

"Increase" Scenario

In a potential "increase" situation, the goal should be to allocate as much of the increase as possible to the depreciable asset, to maximize the basis available for future depreciation deductions to the distributee partner. Planning for this situation is very complex, because this procedure relies on adjusted bases, relative appreciation and relative FMVs. The interaction among these variables gives results that may appear counterintuitive. Exhibit 2 below illustrates this for an increase situation, under the following facts:

Partnership interest FMV    $75,000
Partner's outside basis     $65,000
Equipment adjusted basis    $10,000
Potential depreciation
 recapture                  $40,000
Land FMV                    $25,000
Land adjusted basis         $5,000 - $50,000

[EXHIBIT 2 ILLUSTRATION OMITTED]

For points 1-5 in Exhibit 2 (i.e., distribution of appreciated land), the resulting adjusted basis for the depreciable asset does not change as the land's original basis increases. However, once the basis of the land is greater than its FMV (i.e., the land has unrealized depreciation), the basis allocated to the equipment decreases. The greater the land's unrealized depreciation, the greater the decrease in the basis allocated to the equipment, as illustrated by points 6-10. Thus, if land is distributed, it is best to select appreciated land to distribute with the equipment rather than land with unrealized depreciation, under the facts presented.(13) This will allocate more basis to the equipment in an "increase" situation.

Another alternative is to distribute cash in lieu of, and in an amount equal to the FMV of, the nondepreciable asset. For the scenarios presented, this option will always yield more basis allocated to the depreciable asset, whether the nondepreciable asset has appreciated or decreased in FMV. For example, $40,000 of basis is allocated to equipment if cash is distributed in lieu of the land. This is $21,429 more than the $18,571 maximum allocated to equipment when appreciated land is distributed per the results in Exhibit 2. Thus, in an increase situation, under the facts presented, a distribution of cash when land is available is a better alternative if the goal is to maximize the basis of the equipment distributed. Of course, this can be done only if there is sufficient cash available to distribute to the partner.

Table 1 above summarizes the best type of assets to distribute along with a depreciable asset to maximize the latter's basis. The following conclusions are based on the results, assumptions and analyses of Exhibits I and II: (1) it is better to distribute appreciated nondepreciable assets with equipment than assets with unrealized depreciation and (2) distributing cash in lieu of a nondepreciable asset is a better alternative under the increase, but not the decrease, procedure. Tax professionals should prepare an independent analysis and reach appropriate conclusions for their clients whose situations fall outside of the scope of the facts presented.

Table 1: Summary    Best type of           Is cash equal to FMV
                    nondepreciable         a better alternative
Procedure           asset to distribute    than a nondepreciable
                                           asset?

Decrease             Appreciated                    No

Increase             Appreciated                    Yes

The above analysis examines the selection of nondepreciable assets to distribute with depreciable assets. Another possibility is to distribute multiple depreciable assets without cash or nondepreciable assets. In decrease situations, this will generally yield less favorable results, because the decrease is not shared with nondepreciable assets; thus, all of the decrease reduces the bases of depreciable assets. In increase situations, this will generally yield more favorable results, because all of the increase is allocated to depreciable assets, not shared with nondepreciable assets. This maximizes future depreciation deductions to the partner compared to the other alternatives. In planning for distributions of multiple depreciable assets, the greatest benefit is obtained by maximizing the basis allocated to those with the shortest cost recovery period.

Effect of Sec. 754 Election

If a Sec. 754 election is in effect, under Regs. Sec. 1.732-2(a), the partnership bases of distributed assets must reflect any increases or decreases made previously under Sec. 734(b) for prior distributions. Further, Regs. Sec. 1.743-1 (g) reveals that Sec. 743(b) adjustments to partnership assets with respect to a partner must also be considered when applying the basis allocation rules. The regulations state that a partner that has a Sec. 743(b) adjustment for the particular property received in a distribution must take it into account when applying the basis allocation rules. On the other hand, if a partner receives a distribution of property for which another partner has a basis adjustment, the recipient partner does not take this adjustment into account when applying the basis allocation rules.

Example 13: X, a partner in the XYZ Partnership, has a $1,000 Sec. 743(b) adjustment on a partnership capital asset with a $6,000 FMV and a $3,000 adjusted basis. XYZ distributes the asset to X in a nonliquidating distribution. If X's outside basis in his partnership interest immediately before the distribution is $5,000, he is allocated a $4,000 carryover basis in the asset ($3,000 + $1,000 Sec. 743(b) adjustment).

Example 14: The facts are the same as in Example 13, except that another partner, Y, receives the capital asset in a nonliquidating distribution. Because X has a basis adjustment on the asset, Y does not take the adjustment into account in applying the basis allocation rules. Y would take a $3,000 carryover basis in the distributed asset.

Regs. Sec. 1.743-1(g)(3) provides a special rule for complete liquidations of a partner's interest when he has Sec. 743(b) basis adjustments; all of the partner's basis adjustments must be taken into account. The bases of the assets received are adjusted for specific basis adjustments on the asset, plus the sum of all other basis adjustments on assets of the same character not distributed to the partner. Because the partner is relinquishing an interest in all assets not distributed to him in complete liquidation, the regulations provide for basis adjustments for all these assets to follow the assets of the same character distributed to the partner. Thus, the partner loses no adjustments.(14) Unfortunately, if a partner has basis adjustments for another class of property not distributed to him, such adjustments are lost to him and become part of the partnership property's common basis.

Example 15: J, a partner in JKL Partnership, has a $1,000 Sec. 743(b) basis adjustment on Capital asset 1 and $2,000 on Capital asset 2. In complete liquidation of his interest, J receives Capital asset 2 with an $8,000 FMV and a $3,000 adjusted basis to the partnership. Assuming sufficient outside basis, J has a $6,000 carryover basis for Capital asset 2 ($3,000 adjusted basis + $2,000 adjustment on Capital asset 2 + $1,000 adjustment on Capital asset 1, because he relinquished his interest in it on liquidation).

Planning Strategies

A new consideration in planning for partnership distributions of multiple assets is the need for an appraisal of the assets distributed. This represents an additional cost to the partnership. Under pre-TRA '97 law, the FMV and unrealized appreciation or depreciation were not relevant; thus, an appraisal was not required. Current law considers the asset basis, FMV and unrealized appreciation/depreciation in allocating basis, thereby requiring an appraisal.

In light of the changes to the Sec. 732(c) basis allocation rules, tax practitioners must carefully help clients plan partnership distributions of multiple assets. Understanding the new rules is critical in this planning. Partnerships must consider the tax ramifications to partners of allocating different mixes of assets. The new rules typically minimize gain or loss to a partner on subsequent transfers of assets, because the basis assigned will generally be closer to their FMVs than under pre-TRA '97 law.

When choosing assets to distribute to partners, care must be taken to avoid possible Sec. 751(b) effects. If the distribution is non-pro rata, the complexity and potential negative effects of Sec. 751(b) come into play.

Conclusion

This article reviewed the basis allocation rules for partnership distributions of multiple assets in light of the TRA '97 and IRSRRA '98 changes to Sec. 732(c), and the regulations. It compared the allocation procedures, which consider adjusted bases, FMVs and unrealized appreciation/depreciation to the former rules, which considered only adjusted bases. This comparison is made for both nonliquidating (current) and liquidating distributions. It also discussed both the decrease and the increase procedures.

The article also illustrated that the IRSRRA '98 clarification affects the planning strategy for distributions of depreciable assets. Because depreciation recapture is treated as a separate asset, less basis is allocated to depreciable assets relative to other assets, leading to reduced future depreciation deductions for a partner (compared to when a depreciable asset is treated as a single asset). However, planning opportunities still remain. Careful selection of assets distributed with the depreciable asset can lead to more basis being available for future depreciation deductions.

The article also illustrated the regulation's guidance on applying the basis allocation roles when a Sec. 754 election is in effect with Sec. 743(b) basis adjustments. It concluded by discussing various practical considerations in planning for the distribution of multiple assets.

(1) TD 8847 (12/15/99).

(2) Unless otherwise noted, Sec. 751(b) does not apply to any of the examples in this article; Sec, 736(a) does not apply in any example in which a partner's interest is liquidated.

(3) For this reason, Sec. 754 allows the election of basis adjustments under Secs. 734 and 743. The total adjustment is determined under Sec. 734(b) or 743(b) (and the regulations thereunder); allocation of the adjustment occurs under Sec. 755 (and the regulations thereunder).

(4) There is debate among commentators as to whether gain and income items increase outside basis before distributions (other than draws) reduce it. Compare McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners (WGL, 3d ed., 1997 and 2000 Cum. Supp., No. 1., Vol. 1), [paragraphs] 6.02[5], 10.05[2][a] and 10.03[2] to Willis, Pennell and Postlewaite, Partnership Taxation (WGL, 6th ed., 1997), [paragraph] 13.02[i][6]; see also Rev. Rul. 94-4, 1994-1 CB 195. In this article, it is assumed that gain and income items increase outside basis before distributions reduce it.

(5) The final regulations give examples only for liquidating distributions, because both the increase and decrease procedures apply to them.

(6) Under pre-TRA '97 law, D would have taken a $3,000 basis in Inventory A and a $6,000 basis in Inventory B.

(7) Sec. 732(a)(2). For both liquidating and nonliquidating distributions, a partner recognizes capital gain if the cash distributed exceeds his predistribution outside basis.

(8) The last two sentences of Sec. 751(c), flush language, contain a complete description of items included as unrealized receivables.

(9) A similar bifurcation of assets is delineated in Regs. Sec. 1.751-1(c)(4)(iii), (v) and -1(c)(5).

(10) Actually, Capital asset 1 has $25,000 of unrealized depreciation in A's hands ($50,000 adjusted basis $25,000 FMV).

(11) A computer model was developed for the decrease procedure. Inputs were systematically varied to determine the effect of various factors, including the land's original basis, the relative amounts of increase/decrease in the equipment's and land's FMV and the relative values of the equipment and land distributed; the partner's outside basis was held constant. For the facts presented, the results were always consistent with the theory that more basis is allocated to the equipment under the decrease procedure when it is distributed with appreciated land.

(12) The scenario presented assumes a liquidating distribution to a partner in which the FMV of the assets distributed (i.e., equipment and land) equals the partnership interest's FMV. For other scenarios (e.g., nonliquidating distributions in which the FMV equality assumption would not apply), the results would not necessarily support the same conclusions. A tax professional should perform an independent analysis of alternatives to reach the appropriate conclusions.

(13) A computer model was developed for the increase procedure. Because the procedure applies only to liquidating distributions, it was assumed that the FMV of the assets distributed equaled the partnership interest's FMV. Inputs were systematically varied to determine the effect of various factors, including the land's original basis and the equipment's and land's relative FMVs; the partner's outside basis was held constant. The results were always consistent with the theory that it is better to distribute appreciated land to increase the basis allocated to the equipment. The same results occur when the distributed assets' relative FMVs were changed. The basis allocated to the equipment decreased when the land's relative FMV was increased vis-i-vis the equipment's FMV; however, the theory that it is better to distribute appreciated land with the equipment still held.

(14)Regs. Sec. 1.743-1(g)(3) and (5), Example (v). However, in both article Example 15 and the regulation example, the Sec. 743(b) adjustment is allocated under Sec. 755 to capital gain property (as defined in the Sec. 755 regulations); capital gain property is distributed to the transferee partner in the latter's complete liquidation. If, instead, the transferee partner had received only Cash in complete liquidation, the adjustments would be lost to the transferee/distributee; these adjustments become part of the common basis of remaining partnership property; see Regs. Secs. 1.743-1(g)(1)(ii) and 1.734-2(b).

For more information about this article, contact Dr. Beehler at [phone] or [e-mail].

John M. Beehler, Ph.D., CPA Dean and Professor of Accountancy W. Frank Barton School of Business Wichita State University Wichita, KS